Lessons From the CBS-NAI Dispute: Can Stockholders Rely on Stock Exchange Rules to Prevent Dilution of Their Voting and Economic Interests?

This is the third in a series of posts discussing certain issues and lessons for practitioners arising out of the recently settled dispute between CBS and its controlling stockholder.[1]Relevant background can be found here and additional posts in this series can be found here.

As described in a prior post, on May 17, 2018, the majority of the CBS board (other than the three directors with ties to NAI) considered and purported to approve a dividend of a fraction of a Class A (voting) share to be paid to holders of both CBS’s Class A (voting) common stock and Class B (nonvoting) common stock for the express purpose of diluting NAI’s voting interest in CBS, with the payment of such dividend conditioned on Delaware court approval. In addition to diluting NAI’s voting power from about 80% to about 20%, such dividend would have also diluted the voting rights of other Class A stockholders.

Although it is not clear from the public record whether and to what extent the non-NAI-affiliated directors considered the NYSE’s Shareholder Approval Policy in approving the dividend, NAI believed that the proposed dividend (which was not conditioned on stockholder approval) raised serious issues under that NYSE Policy.

As a company with shares listed on the NYSE, CBS is subject to the corporate governance requirements set forth in the NYSE’s Listed Company Manual, including the requirement that a listed company must obtain stockholder approval before it can issue common stock if the common stock being issued will, upon issuance, constitute 20% or more of the voting power outstanding immediately before the issuance of such stock.[2] While there are express exceptions to the “20% rule,” no such exception was applicable in this instance.[3]

CBS may have relied on a prior NYSE statement indicating that “[the rule] does not apply to stock dividends and stock splits because they are distributions rather than transactions.”[4] It appears, however, that the underlying purpose of the NYSE’s statement may have been solely to permit the distribution of pro rata dividends that do not redistribute relative voting power among stockholders.[5] This was not the case with the dilutive dividend the CBS board purported to approve. In the Exchange Act Release adopting the 20% threshold (an increase from the prior 18.5% threshold), the SEC confirmed the legislative history behind this intent, noting that “by expressly amending the rule to take into account the ‘voting power outstanding’ in addition to the number of shares outstanding when determining when a shareholder vote is needed for various issuances the rule will focus more specifically on the actual effect of an issuance on shareholders. This is particularly true for companies with dual class capital structures where the classes have different voting rights.”[6] Consequently, we believe there is a substantial argument that the stockholder approval requirements set forth in Section 312.03(c) of the Listed Company Manual would (and should) apply to a dilutive stock dividend.

This argument is bolstered by Section 313 of the Listed Company Manual, which reaffirms the NYSE’s view of the importance of maintaining the voting rights of existing stockholders, stating unambiguously that, “[v]oting rights of existing shareholders of publicly traded common stock registered under Section 12 of the Exchange Act cannot be disparately reduced or restricted through any corporate action or issuance.”[7]

It is possible that the non-NAI-affiliated directors of CBS were advised of issues raised by the NYSE Policy but balanced what they believed were the anticipated benefits and importance of the dilutive dividend against the negative aspects, including the risk of potential NYSE enforcement action. For example, they may have concluded that the NYSE might not focus on that language or might be reluctant to exercise its principal method of enforcement – delisting the shares of a non-compliant company – because that would have had a negative effect on public stockholders and their ability to obtain liquidity for their shares, particularly at a time of significant corporate developments. Conceivably, directors could obtain expert advice on the likely degree of liquidity and pricing that would be lost as a result of a delisting and steps that could be taken to limit those effects.

Although it is often taken as a given that the NYSE’s stockholder voting requirements will be followed, it is likely that those requirements do not have the force of law and stockholders do not have the right to enforce the requirements.[8] As such, stockholders of an NYSE-listed (or NASDAQ-listed) company should not blindly assume that an issuer will comply with the applicable exchange’s rules in every situation. There may be instances where directors of a board are willing to bear the risk of delisting – and in fact, feel justified (rightly or wrongly) in doing so – to achieve some other aim that they believe is paramount. The issue could arise in the context of a control fight, as in the case of CBS and NAI, but could arise in other circumstances as well (e.g., the need for an acquirer to issue common stock in connection with an acquisition where a stockholder vote condition could make the proposal uncompetitive).[9]

In any such circumstance in which the issuance could lead to a delisting, the board will need to take into account the potential effect that might have on stockholders’ liquidity as part of the broader mix of considerations, but the existence of an exchange rule may not act as an absolute bar. This is true whether the action taken by the board is, as a corporate law matter, subject to review under the business judgment rule, or is subject to review under Unocal/Unitrin if taken for defensive purposes or under the “compelling justification” standard of Blasius[10] if “intended primarily to thwart effective exercise of the [stockholder] franchise” as asserted by NAI in the case of the proposed CBS dilutive dividend. Regardless of the standard of review, the CBS-NAI situation should serve as a reminder that stockholders should be wary of relying too heavily on stock exchange rules as protection against potential dilutive stock issuances.

[1] Cleary Gottlieb was litigation and corporate counsel for NAI in the matters discussed herein.

[2] More specifically, Section 312.03(c) of the Listed Company Manual states, “Shareholder approval is required prior to the issuance of common stock, or of securities convertible into or exercisable for common stock, in any transaction or series of related transactions if: (1) the common stock has, or will have upon issuance, voting power equal to or in excess of 20 percent of the voting power outstanding before the issuance of such stock or of securities convertible into or exercisable for common stock; or (2) the number of shares of common stock to be issued is, or will be upon issuance, equal to or in excess of 20 percent of the number of shares of common stock outstanding before the issuance of the common stock or of securities convertible into or exercisable for common stock.”

Similarly, the NASDAQ and the NYSE American LLC also have their own “20% rules,” although each of the exchanges has a slightly different formulation for its 20% rule, and care must be taken as such differences may lead to different outcomes for any particular issuance under consideration.

[3] Situations in which stockholder approval would not be required include: (a) any public offering for cash or (b) any issuance involving a “bona fide private financing” if such private financing involves a sale of: (i) common stock, for cash, at a price at least as great as each of the book and market value of the issuer’s common stock; or (ii) securities convertible into or exercisable for common stock, for cash, if the conversion or exercise price is at least as great as each of the book and market value of the issuer’s stock.

[5] This is always the case for companies with one class of common stock, and is normally the case for companies with multiple classes of common stock where holders of each class only receive additional shares of the particular class they already hold.

[7]Section 313 of the Listed Company Manual (emphasis added). In one of its published interpretations of Section 313, the NYSE stated that an exchange offer providing for the exchange of common stock having one vote per share for preferred stock having 0.8 votes per share was not prohibited by Section 313 because it “would have a de minimis effect on voting rights.”

[9] Indeed, we are aware of at least one situation where the board of a major company seemed to be prepared to not comply with the NYSE Policy in the context of a competitive M&A situation, after receiving advice as to the likelihood of an NYSE enforcement action and the likelihood of other trading markets developing in the event of a delisting. (The transaction ultimately did not proceed for other reasons.) Of course, in some circumstances this problem can be avoided by issuing convertible preferred stock that cannot convert into excessive voting shares unless and until stockholder approval is obtained.